Four trends which make a strong case for RBI rate hike

Voices of dissent against the Reserve Bank of India’s (RBI’s) persistent monetary tightening have grown louder in recent months. A number of arguments have been put forth expressing the fear that the RBI might have hiked interest rates once too often to be good for the economy.

Inflation, for instance, is seen as more driven by supply-side constraints, rendering monetary policy ineffective. There has also been a softening in credit growth, the main channel for monetary policy transmission.

Signs of a cooling off in the economy are visible in the latest gross domestic product (GDP) numbers, while the weak global environment keeps the mood solemn.

[caption id=“attachment_78871” align=“alignleft” width=“380” caption=“Signs of a cooling off in the economy are visible in the latest gross domestic product (GDP) numbers. AFP”] [/caption]

But a closer look at the numbers shows that the RBI indeed has strong counter-arguments for its hawkish monetary stance. Inflation is being driven significantly by discretionary or optional spends, and sector-wise credit shows high growth in speculative and consumption offtake. GDP (ex-agriculture) is accelerating and foreign trade and investments are robust despite the global slump.

These factors make for a strong case for an interest rate hike at the 16 September central bank meeting.

Here are four major arguments presented against a rate hike, and the potential counter-arguments to them:

Argument #1 - Inflation is supply-driven: It is argued that interest rate hikes will not help in bringing inflation into check, since they are being driven more by supply constraints than by increased demand. Typically, the food and fuel groups of the Wholesale Price Index (WPI) are seen as supply side indicators and ‘core inflation’, i.e. inflation ex-food and fuel, is the demand-driven component.

Counter-argument: While it is true that food prices have contributed significantly to the headline price index - over the past one year over 20 percent of the price increase has been due to food articles inflation - the real story is in the components of food prices. Inflation of staple foods like rice, wheat, pulses and even vegetables has been below 5 percent for 2011-12 so far.

In contrast, discretionary spends like fruits, coffee and spices have shown a far higher increase in inflation of over 20 percent during the period. Of these, supply constraints are visible only in fruits - where as much as 40 percent of fresh produce can go waste due to lack of storage. But for items like coffee and spices, a robust domestic demand plays a strong role. Change in consumption patterns is also responsible for rising inflation in food products like eggs, fish and meat.

Argument #2 - Credit growth is showing signs of coming off: Some moderation in credit growth is visible. As per the latest numbers (12 August 2011), credit grew by 20.2 percent, a tad lower than the 21.7 percent average growth over the past 12 months. This is likely to be on account of the monetary tightening measures undertaken by the RBI. When the full lagged-impact of the rate hikes comes in, credit growth might slow down even more.

Counter-argument: The decline in credit growth camouflages two important trends in credit demand. One, credit growth is barely down from the corresponding period of the previous year. In fact, from August 2010 to now, there is no change in the credit growth rate.

Second, a look at the breakup of credit growth reveals an unsettling trend. Growth in loans to non-banking finance companies, commercial real estate and personal loans (for housing, credit card outstandings and vehicles) during June 2011 has actually accelerated in comparison to the same period of the previous years, even while industry’s credit offtake has declined.

Loans to NBFCs have accelerated 44.5 percent (from 25 percent), while commercial real estate loans have grown by 23.2 percent (from a decline of 4.5 percent during the previous year) and personal loan growth has risen to 17.3 percent (from 6.6 percent), as per the RBI’s data. The central bank is watchful of speculation and the formation of asset bubbles, particularly in real estate.

In fact, it has recently released a report for further regulation in NBFCs, which, among other things, seeks to increase risk weightages for NBFC loans to capital markets and commercial real estate. The accelerated growth in personal loans indicates consumers’ ability and willingness to spend more.

Argument #3 - Real economic growth is softening: The impact of monetary tightening is evident in economic growth. GDP growth declined to 7.7 percent in the first quarter of 2011-12, in comparison with 8.8 percent in the corresponding period of the previous year. Industrial production, in particular, has been declining. It is feared that too many interest rate hikes will kill domestic demand and slowdown the economy.

Counter-argument: An overall cool-off in GDP from the previous year actually masks the fact that activity has actually strengthened in the first quarter of 2011-12. If we look at GDP ex-agriculture, which is more impacted by interest rates, there is actually a pickup in activity this quarter after four quarters of a secular decline. At 8.4 percent, in the first quarter 0f 2011-12, it is the strongest growth since the second quarter of 2010-11. While industry has indeed slowed down, this trend is largely due to an acceleration in services GDP to a four-quarter high.

Argument #4 - A weak global scenario can negatively impact India: The advanced economies of the US and the eurozone have gone back into a recessionary mode. While the US grew by 1 percent in the second quarter of 2011, the eurozone grew by an even more feeble 0.2 percent. Recent activity indicators also point to continued muted growth. These can impact India’s economic prospects by denting exports and investments.

Counter-argument: The impact of the global recession has been witnessed in both India’s exports and investments during the last two years. However, the current fiscal year so far shows a robust trend in growth on the external front. Foreign direct investments (FDI) into India have increased by 133 percent over the previous year for the April-June 2011 period to $13.4 billion.

While this is partly due to a base effect, it also reflects a genuine increase in investments into India. Exports have grown by over 53 percent during the April-July 2011 period. Like investments, these too are partly due to a weak base, but it does not take away from genuine export demand growth.

In sum, while the overall trends do indicate that some softening is taking place, on scratching the surface we see a different picture. It is likely that the RBI is looking as much as the detailed picture as the broad trends. And this picture does suggest that the RBI is not quite done with interest rate hikes for now.

Manika Premsingh is the promoter of Orbis Economics, which provides research on the economy.